Wednesday, October 28, 2009

More than you probably ever wanted to know about the Hamp

Posted on FT's Alphaville by Tracy Alloway:

The Federal Reserve Board had just released a working paper on the Home Affordable Modification Plan — the Hamp.

The paper is fantastic for details on just how the programme — which is aimed at making mortgages more affordable by reducing interest payments — came about and feeds into the wider financial system. When it comes to the programme’s potential success, authors Larry Cordell, Karen Dynan, Andreas Lehnert, Nellie Liang and Eileen Mauskopf think the Hamp will help a lot of homeowners — but they do see limitations.

Of particular note is the idea that the Hamp might not be helping those who need it most:

Nonetheless, millions of foreclosures are likely to occur over the next couple of years. House price declines have led to a sharp deterioration in the financial situation of many homeowners, leaving them less willing or able to afford even reduced mortgage payments. Further, HAMP modifications are not well-suited to address many cases where homeowners have suffered a large temporary decline in income, as might be the result of job loss. In particular, because the modification calls for a reduction in the ratio of payments to income based on the current level of income, a reduction that would not be reversed if income were to return to its previous level, the required modification in such cases will often be too costly to qualify the program.

Which means that because the size of the reduction in payments permanently depends on current income (virtually none in the case of the unemployed) — the loan modification could turn out to be overly generous. Once the jobless homeowner resumes work he will still be making Hamp payments based on his unemployed income — and those bearing the cost of the Hamp exercise will be left to pick up the tab. Furthermore:

In addition, the program may not be very effective when the value of the mortgage greatly exceeds the value of the home. Some borrowers who believe that there is little prospect for house prices to recover enough to put the mortgage “above water” within some reasonable period of time will not participate in the program and instead walk away from their mortgages. Worse yet, other borrowers may shift beliefs only after entering the program; these borrowers are likely to default after many of the costs associated with the modification have already been borne.

Which is a problem that’s been mentioned before. If you are say, a homeowner offered a Hamp trial modification plan where your monthly payments are reduced, you could easily walk away after making a few cheap payments. We’ve noted one instance where a Hamp modification plan entailed monthly payment of $1170 a month, when comparable houses were renting for close to $1,500 a month. That’s a bargain for the (underwater) homeowner.

But it’s not so great for the people and institutions assuming the cost of the modifications:

The HAMP protocol requires servicers to lower monthly mortgage payments, which include principal, interest, taxes and insurance (PITI), to 38 percent of the borrower’s gross income, through any method they choose, with investors bearing the losses implied by the reduced payments. Servicers are then required to reduce the DTI [payment to current income ratio] from 38 percent to 31 percent by using the waterfall provided by the plan; the losses associated with the additional reductions in the DTI are shared equally by the government and the investors

Now a typical mortgage investor is someone like Greenwich Financial Services. But they also include Fannie and Freddie — the government-sponsored enterprises. Banks tend to be on the mortgage lending and servicing side of things — which presumably is why you sometimes see them lobbying for more aggressive Hamp action. Servicers and lenders get payments for Hamp participation — the trade-off is they have to commit a lot of time and resources to the actual modification process.

Anyway, back to the GSEs:

For loans owned or guaranteed by the government-sponsored entities, the modification may proceed even if the present value of the modified revenue stream is less than that expected to be obtained under foreclosure. In all cases, the GSE buys the loan out of the pool, the investor is made whole with respect to the remaining balance on the loan. Under the Treasury’s commitment to maintain a positive net worth for the GSEs, the cost of the modification may ultimately be borne by the taxpayer. (23)

23 These modification costs are over and above the Treasury incentive payments under HAMP. Given the Treasury’s commitment to the GSEs, a modification that lowers the borrower’s payments means that the taxpayer receives a lower return than he would under the terms of the original loan when the loan is owned or guaranteed by the GSEs.

Got it? Mortgage investors get lower payments. Mortgage lenders and servicers get Hamp bonus incentives and Fannie and Freddie get Treasurized.

The argument of course, is that a loan modification will ultimately be cheaper than foreclosure — though some of that loses weight if you consider that a Hamp homeowner dragging out proceedings in an environment of declining houseprices, will mean losses from delaying foreclosure could be larger than losses if foreclosure had been initiated immediately. The authors say incentive payments — linked to the rate of recent home price decline — should mitigate this.

But the historic evidence presented from the paper is not encouraging.

The authors, for instance, looked at 5.5m active loans in the First American CoreLogic Loan Performance ABS database as at March 2009. Of note:

. . . the performance of loans modified as of March 2009 was poor, as only 40 percent of modified loans were current at 6 months after modification, and 29 percent were seriously delinquent. Given that loans are marked as seriously delinquent if they have missed three or more payments or are in foreclosure, such borrowers likely made only one or two payments on their modified loan.

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